In modern terms, a merchant bank is a firm or financial institution that invests equity capital directly in businesses and often provides those businesses with advisory services. A merchant bank offers the same services as an investment bank; however, it typically services smaller clients and makes direct equity investments in them.
Merchant banks mainly work with small-scale enterprises that are unable to raise funds through an initial public offering (IPO) by providing mezzanine financing, bridge financing, equity financing, and corporate credit products. They also issue and sell securities on behalf of corporations through private placements to refined investors who require less regulatory disclosure.
Large merchant banks place equity privately with other financial institutions by acquiring a considerable share of ownership from companies with a significant potential for a high growth rate to seal the gap between venture capital and public stock.
History of Merchant Banks
The history of merchant banks can be traced back to Italy in the late Medieval times as well to France in the 17th and 18th centuries. Merchant banks began operating as organized money markets consisting of merchants financing the transactions of other merchants. French merchant Marchand Banquer invested all his profits by integrating the banking business into his merchant activities and became a merchant banker.
In the United Kingdom, merchant banks started in the early 18th century. The oldest merchant bank in the United Kingdom is Barings Bank, which was established by a German-originated family of bankers and merchants. It was founded in 1762 and was the second oldest merchant bank in the world after Berenberg Bank. The bank was, at one time, referred to as the sixth great European power after Germany, Russia, the United Kingdom, Austria, and France after it helped finance the US government during the 1812 War.
The growth of trade and industries in the 19th century led to the emergence of merchant banks in the United States. The first merchant banks in the United States were JP Morgan & Co and Citi Bank. The industry was mainly dominated by German-Jewish immigrant bankers and Yankee houses with close ties to expatriate Americans who settled in London as merchant bankers.
However, with the growth of the financial world, corporations overshadowed family-owned businesses in the banking business. The corporations included merchant banking as one of their areas of interest, a characteristic that banks hold until today.
Functions of Merchant Banks
Merchant banks perform a number of functions, including the following:
1. Equity Underwriting
Large companies often employ the services of merchant banks in acquiring capital through the stock market. Equity underwriting is achieved by evaluating the amount of stock to be issued, the value of the business, the use of proceeds, and the timing of issuance of the new stock. Merchant banks handle all the necessary paperwork and liaison with the appropriate marketing division to advertise the stock.
2. Credit Syndication
Merchant banks help in processing loan applications for short and long-term credit from financial institutions. They provide these services by estimating total costs involved, developing a financial plan for the entire project, as well as adopting a loan application for commercial lenders.
Also, they assist in choosing the ideal financial institutions to provide credit facilities and act on the terms of the loan application with the financiers. Merchant banks also ensure the lender’s willingness to participate, organize bridge finance, and engage in legal formalities regarding investment to be approved and check the working capital requirements.
3. Portfolio Management
Merchant banks provide portfolio management services to institutional investors and other investors. They help in the management of securities to enhance the value of the underlying investment. Merchant banks may assist their clients in purchasing and selling securities to help them attain their investment objectives.
Investment Bank vs. Merchant Bank
Although there is somewhat a thin line between traditional merchant banks and investment banks, the financial institutions differ in several ways. First, merchant banks serve small-scale companies that may not be big enough to attract funding from venture capitalists and other large investors.
Merchant banks offer such companies creative credit products such as bridge financing, equity financing, and mezzanine financing. They place equity with other financial institutions and take ownership of small but promising companies.
Investment banks, on the other hand, focus on underwriting and selling securities through initial public offerings (IPO) and share offerings. Unlike merchant banks that focus on small companies with potential for growth, an investment bank’s clientele comprises large companies with enough resources to finance the sale of securities to the public. Investment banks advise their clients on mergers and acquisitions, buyouts, and capital restructuring, among other services.
Traditional merchant banks mainly focus on international financing activities including trade finance, foreign corporate investment, and foreign real estate investment. Some of these activities may be shared with investment banks. Still, there are other functions like issuing letters of credit and international funds transfer that are predominantly carried out by merchant banks.
Investment banks focus on raising funds for corporations and governments and issuing debt or equity on the market. This is a transition from their traditional roles of underwriting and selling securities. Investment banks also help in mergers and acquisitions as well as buying and selling large companies.
Thank you for reading CFI’s guide to Merchant Banks. To keep advancing your career, the additional CFI resources below will be useful: